As a business owner, you may be able to claim a deduction for income that cannot be recovered from a customer or debtor. This unrecoverable income is also known as a 'bad debt'.
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The accounting method you use to account for your assessable income affects whether you can claim a bad debt deduction:
If you account for your assessable income on an accruals basis, you may be required to include an amount you earn as assessable income in your tax return before you receive payment of that amount.
If you determine there is no or little likelihood that an amount included in your assessable income will be recovered from the debtor, you may be able to claim that amount as a tax deduction.
To claim a deduction for the assessable income that cannot be recovered, you need to write off the unpaid amount as a bad debt (see How to write off a debt as bad).
If you subsequently recover an amount that you wrote off as a bad debt and claimed as a tax deduction, the amount you recover must be included in your assessable income when you receive it.
Writing off a debt as bad is not the same as waiving or forgiving a debt. There are different tax consequences for debt forgiveness or waiver and there may also be tax consequences for the debtor.
If you account for your assessable income on a cash basis, you will not include an amount in your assessable income until it is received. Therefore, writing off, forgiving, or waiving a debt for an amount of unpaid income will have no income tax consequences for you.
A bad debt deduction may be claimed where you account for your assessable income on an accruals basis.
To claim a bad debt deduction in an income year for an amount included in your assessable income that has not been recovered, you must do all of the following:
You can only claim a bad debt deduction for amounts you have included in your assessable income, either in your tax return for the year you claim the deduction or in an earlier income year.
You need to determine that the debt is bad at the time you propose to write it off. The debt must not be merely doubtful. There must be a debt owing to you and it is genuinely bad. This means it must be an amount that you have determined is unlikely to be recovered through any reasonable and commercial attempts.
Depending on your circumstances, this does not always mean you need to have commenced formal proceedings to recover the debt (see example below). There are many ways to demonstrate an amount is no longer recoverable, and what constitutes a reasonable attempt will depend on the circumstances. For example, you may provide evidence of communications seeking to obtain payment of the debt, including reminder notices issued and attempts to contact the debtor by phone/mail.
You need to write off the debt as bad before you can claim it as a bad debt deduction. This means you must have made the decision to write off the debt and recorded that decision in writing before the end of the income year in which you claim a deduction. For example, you may have removed the debt from the customer’s account and recognised a bad debt expense.
The debt must still be in existence, and not otherwise dealt with, when you write it off and claim a deduction. For example, you must not have waived or forgiven the debt, extinguished the liability in another way, or sold the debt.
If you are a company, before you deduct a bad debt, you must satisfy the continuity of ownership test. If you do not satisfy the continuity of ownership test, you can still deduct the bad debt if:
- For debts incurred prior to 1 July 2015 which are written off as bad – you satisfy the same business test, as set out in Taxation Ruling TR 1999/9.
- For debts incurred on or after 1 July 2015 which are written off as bad – you satisfy one of the tests relating to the continuity of business
- the same business test, as set out in Taxation Ruling TR 1999/9, or
- the similar business test, as set out in Law Companion Ruling LCR 2019/1.
There are also special bad debt deduction rules for:
- tax consolidated groups and multiple entry consolidated groups
- trusts (subject to certain exclusions, including for trusts that have made a family trust election)
- where the taxation of financial arrangement (TOFA) rules apply to you.
- Law Companion Ruling 2019/1 The business continuity test – carrying on a similar business
- Taxation Ruling TR 1999/9 Income tax: the operations of sections 165-13 and 165-210, paragraph 165-35(b), section 165-126 and section 165-132
- Taxation Ruling TR 92/18 Income tax: bad debts
- Trust loss provisions
- Guide to taxation of financial arrangements (TOFA)
There are generally no other tax consequences merely because you write off a debt as bad.
Writing off a debt as bad is not the same as waiving or forgiving a debt or if the debt otherwise comes to an end. This applies whether or not you have previously chosen to write it off as bad.
There may be other tax (including CGT) consequences when a debt comes to an end and there may also be tax consequences for the debtor.
- Debt forgiveness and CGT
- Working out your capital gain or loss
- Debt forgiveness by private companies
- Guide to taxation of financial arrangements (TOFA)
If you account for goods and services tax (GST) on a non-cash (accruals) basis, you can claim a decreasing adjustment for a bad debt if:
- you made a taxable sale and have paid GST to the ATO for that sale
- you have not received the consideration, either in whole or in part, for the taxable sale, and
- you write the debt off as bad or the debt has been overdue for 12 months or more.
The ways to demonstrate that a debt is bad for income tax purposes also apply to when a debt is considered bad for GST purposes. Similar to income tax, you cannot write off a debt as bad if you have forgiven the debt or set it off against other liabilities.
You can make the decreasing adjustment for the tax period in which you:
- write off the debt, or
- become aware that the debt was overdue for 12 months or more.
If you claim a decreasing adjustment after writing off a debt as bad or where a debt was overdue for 12 months or more, and subsequently recover some or all of that debt, you will have an increasing adjustment in the tax period in which you recover the debt.
Landlord Pty Ltd owns a commercial property and leases it to Tenant Pty Ltd. The lease income is included in Landlord Pty Ltd’s assessable income on an accruals basis (that is, when an invoice for rent due is issued to the tenant). Throughout the relevant period, there have not been any changes to the ownership structure of Landlord Pty Ltd.
On 15 March 2020, Landlord Pty Ltd issued an invoice to Tenant Pty Ltd for $15,000 for rent for the preceding 6 months. Under the accruals basis, Landlord Pty Ltd included this amount in its assessable income for the year ended 30 June 2020.
After the invoice issued, Tenant Pty Ltd vacated the property without notice, and the owners of the company were uncontactable. During the 2019–20 income year – despite numerous unsuccessful attempts to recover the unpaid invoice – Landlord Pty Ltd concluded that it was unlikely to be recovered. Landlord Pty Ltd has no security from Tenant Pty Ltd for the unpaid rent and determines that legal action to recover the amount would not be commercially viable.
Even though Landlord Pty Ltd has not commenced legal proceedings against Tenant Pty Ltd, the unpaid rental invoice can be considered a bad debt. If the debt is written off in the same income year as it became a bad debt (that is, before 30 June 2020), Landlord Pty Ltd can claim a deduction of $15,000 for the bad debt written off.
Landlord Pty Ltd is registered for GST and accounted for GST on the supply of the commercial premises in its March 2020 activity statement. Landlord Pty Ltd can claim a decreasing adjustment in the tax period that the bad debt is written off.End of example
Note: Most individual investors who rent out a small number of residential properties account for their rental income on a cash basis. If you are such a taxpayer, writing-off any unpaid rent as a bad debt will have no tax consequences.Information about income that cannot be recovered (or a 'bad debt') and how to write off a debt as bad.